The New “Hope Note”
New Hope or New Risk for Commercial Real Estate?
March 1, 2011
Hope has been the inspiration for many great things in history. Columbus discovered the Americas hoping to find a quicker and more direct route to the Far East. Now there is hope for the commercial real estate industry and its “Queen Isabella,” the lending and mortgage industry. A new strategy is emerging called a “Hope Note.” To understand what it is, you must first understand what led to its creation.
Sharks in the Water
For the past two years, many in the commercial real estate industry have waited for a market meltdown, when property owners would walk away and lenders would dump both good and bad properties at deep discounts. Hungry investors accumulated cash with hopes of scooping up commercial real estate at once-in-a-lifetime prices.
In certain areas of the country, this scenario has occurred, to some extent. Yet in many other markets, such as Utah, the volume of lender-owned or lender-forced sales of commercial real estate has been limited. The threat of a large number of “distressed assets hitting the market soon” slowed regular market transactions to a trickle because non-distressed owners chose not to put their properties up for sale at a time when buyers were acting like sharks in the water. The result? There have been very few commercial real estate transactions, either distressed or non-distressed, over the past two years. Based on Utah sales data, 2010 showed the lowest volume in both transaction and dollar volume since 2001.
The limited number of transactions made lenders very reluctant to approve new loans on commercial real estate. They were also less aggressive with borrowers that had reduced equity or difficulties. With fewer sales, lenders had no yardstick of comparison and became very unsure of the current market value of real estate. They were justified in being conservative when asked to underwrite new loans or to refinance maturing loans. This abundance of caution further slowed real estate activity, even though the economy appears to be rebounding of late.
Extend and Pretend
Most commercial real estate lenders have been hesitant to force foreclosure or to work through the lender-owned (REO) backlog with sales at current market values. Much of this reluctance can be attributed to the damage done to lenders’ balance sheets after the financial market meltdown late in 2008. Lenders did not want to write down the balance of their non-performing real estate assets to current market values. If they had, many would have fallen below their loan/loss ratios, resulting in more failed lending institutions.
The “wait-it-out” strategy—in which lenders sat on loans, waiting for the market to improve—became known as the “extend-and-pretend” period. In reality there was little pretending and financial regulators were very active in pushing lenders to build up reserves against future losses, often to a level that far exceeded the risk of loss.
Today, a number of lenders have too many commercial real estate loans on their books at levels not justified by current market values. These loans present a twofold problem: they tie up deposits as reserves and require extensive personnel to manage and monitor their status.
The New “Hope Note”
Several large regional lenders have come up with a new solution to this problem. It is called a “Hope Note,” and it is a form of loan restructuring. This is a relatively new idea. The original loan is restructured into two parts. One part is based on the borrower’s ability to pay on the reduced current market value. The second part includes a new note for the remaining balance of the original loan. This loan is carried on the books in “hope” that the market will eventually recover. If property values go back up and cover part or all of the Hope Note, both the borrower and lender benefit. The borrower will have a reduced loss and the lender will have a smaller write-down. In the meantime, the lender finds relief because the newly created loans can be backed by a lower reserve since only the “Hope” portion of the loan is considered at greater risk.
This new tool strengthens the balance sheet of the lender. Hope Notes are very similar to subprime loans. They are a mortgage based on real estate but do not have collateral value to back them up.
The Risk Behind Hope Notes
This type of loan restructuring gives lenders an extension on the time between loan default and the need to foreclose or force a sale. The Hope Note method is only one of the reasons that more lender-owned properties have not yet made it to market. However, this type of financial engineering does not solve the problem but only puts it off for another day. If property values rebound, the strategy is good for all involved. However, if values stagnate or decline, the problems for the industry may be compounded.
Recently, lenders that weathered the worst of the storm have reentered the commercial real estate market. In December 2010, the Commercial Mortgage Backed Securities (CMBS) market experienced a huge increase in the percentage of loans reaching maturity and being paid off through refinancing. This is a positive trend for increased market activity and may be sufficient evidence to lenders that there is indeed an active market for commercial real estate. Not only will that allow them make a new loan, but hopefully deal with existing loans through the typical market process and not with financial engineering.
John Taylor is director of corporate services at Utah-based Commerce Real Estate Solutions. He can be reached at 801-303-5415 or firstname.lastname@example.org